China Economic Journal

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Understanding the U.S.-China Trade War

Tao Liu & Wing Thye Woo

To cite this article: Tao Liu & Wing Thye Woo (2018): Understanding the U.S.-China Trade War,
China Economic Journal, DOI: 10.1080/17538963.2018.1516256

To link to this article: https://doi.org/10.1080/17538963.2018.1516256

Published online: 04 Oct 2018.

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CHINA ECONOMIC JOURNAL
https://doi.org/10.1080/17538963.2018.1516256

Understanding the U.S.-China Trade War

Tao Liua and Wing Thye Woob,c,d,e
a
Central University of Finance and Economics, China; bUniversity of California, Davis, USA; cSunway
University, Malaysia; dFudan University, China; eChinese Academy of Social Sciences, China

ABSTRACT KEYWORDS
Three major concerns drove the U.S. into initiating the trade war, and Trade war; currency
they are (a) the concern that China’s chronically large trade surplus was manipulation; forced
technology transfer; U.S.-
depressing job creation in the U.S. (b) the concern that China was China relation
using illegal and unfair methods to acquire U.S. technology at an
effectively discounted price; and (c) the concern that China seeks to JEL CLASSIFICATION
weaken U.S. national security and its international standing. On the F13; F32; F41; F52; O19; O32;
dispute over China’s exchange rate and trade imbalance, the first O34; P33
conclusion is that it was marked by analytical confusion over the
meaning of the term ‘equilibrium exchange rate’. The second conclu-
sion is that China’s trade imbalance reflects the economic conditions in
both China and U.S., and that the efficient and fair solution of the
problem requires policy changes in both countries. On the industrial
policy dispute, the first conclusion is that the issue of forced technol-
ogy transfer is largely a dispute about China using its market power to
benefit itself at the expense of its trade partners. The second conclu-
sion is that China’s use of market power can last only until the other
large countries could unite and retaliate as a group. The inevitability of
retaliation means that China should replace the joint-venture (JV)
mechanism for technological diffusion with other ways to strengthen
its technological capability. On the U.S. concern about whether China
trade weakens its national security, the first conclusion is that the
notion of national security that is commonly adopted in the U.S.
trade policy debate is ignorant about the primary determinants of U.
S. capability in innovation. By focusing instead mainly on how to hold
down China technologically, the long-run outcome will be a techno-
logically weaker U.S. and hence, a more vulnerable U.S. The second
conclusion is that the U.S. must identify a clear, short list of critical
technologies and critical infrastructure for the recently reformed
Committee for Foreign Investment in the United States (CFIUS) to
cover, and update this list constantly. Otherwise, the broad and chan-
ging nature of notions about national security would allow the bureau-
cratically driven phenomenon of mission-creep to steadily expand the
coverage of the CFIUS process, thereby steadily rendering CFIUS to be
operationally capricious. Our principal policy suggestion to China is
that, because China’s economy in 2018 is very different from that in
1978 (e.g. many parts of China now look like Singapore and China is
Africa’s biggest donor), there should be more reciprocity in China’s
trade and investment relations with the advanced economies despite
China’s status as a developing economy under WTO rules. Our princi-
pal policy suggestion to President Trump is to stop equating strategic
competition with economic competition. Strategic competition is nor-
mally a zero-sum game. While fair economic competition is usually a

CONTACT Wing Thye Woo wtwoo@ucdavis.edu University of California, Davis

© 2018 Informa UK Limited, trading as Taylor & Francis Group
2 T. LIU AND W. T. WOO

zero-sum game in the short run, it generally creates a win-win out-

come in the long run.

Introduction
As this article goes to press in early August 2018, China and the U.S. are engaged in a
trade war that looks very likely to escalate. The U.S. implemented a 25 percent tariff on
6 July 2018 on Chinese imports that had amounted to $34 billion in 2017 and is
planning to impose the 25 percent tariff on additional Chinese imports worth $16
billion on 23 August 2018. And China has responded in a tic-for-tac manner to this
two-part U.S. tariff action.
In reaction to the Chinese retaliation, the U.S. has announced that it would impose
25 percent tariff on another $200 million worth of Chinese goods. In quick reply, China
promised to respond with 25 percent tariff on $60 billion more of U.S. imports. Why
did China not match the U.S. action in scale in this likely second round of the trade
war? The answer is that China’s export of goods to the U.S. was $505 billion in 2017,
while U.S. exports to China was only $130 billion.
Needless to say, both the U.S. and China have been hurt by the trade war. $27 billion of
U.S. agricultural exports have been adversely affected by Chinese tariffs implemented on 6
July 2018, and the U.S. now plans to dole out $12 billion in subsidies to U.S. farmers.
China has eased up on credit growth in the last month to offset the negative consequences
of U.S. tariffs, effectively suspending its efforts to reduce the debt-GDP ratio which stands
at the dangerously high level of 300 percent compared to 170 percent in 2009.1
Three major concerns drove the U.S. into initiating the trade war, and they are (a)
the concern that China’s chronically large trade surplus was depressing job creation in
the U.S.; (b) the concern that China was using illegal and unfair methods to acquire U.
S. technology at an effectively discounted price; and (c) the concern that China seeks to
weaken U.S. national security and its international standing.
China’s journey in external economic engagement has been marked by many
disputes, and it is safe to predict that its future course will generate new disputes.
This paper hopes to help reduce the intensity and frequency of these future interna-
tional economic disputes by evaluating (a) two protracted and cantankerous external
economic disputes of the last 40 years – the disputes over China’s chronic large trade
surplus and over China’s industrial policy – and (b) the hypothesis that trade with
China undermines U.S. national security.
To anticipate the coming discussion in the paper, we will summarize some key
conclusions here.
On the dispute over China’s exchange rate and trade imbalance, the first conclusion
is that it was marked by analytical confusion over the meaning of the term ‘equilibrium
exchange rate’. The second conclusion is that China’s trade imbalance reflects the
economic conditions in both China and U.S., and that the efficient and fair solution
of the problem requires policy changes in both countries. The third conclusion is that
the dispute on exchange rate misalignment has diverted attention away from better
solutions that (a) address the underlying structural factors causing the trade imbalance,
 CHINA ECONOMIC JOURNAL 3

and (b) improve the of U.S. job transition programs whose inadequacy has exacerbated
U.S. unhappiness with trade imbalance.
On the industrial policy dispute, the first conclusion is that the issue of forced
technology transfer is largely a dispute about China using its market power to benefit
itself at the expense of its trade partners. The second conclusion is that China’s use of
market power can last only until the other large countries could unite and retaliate as a
group. The inevitability of retaliation is why we do not see the imposition of optimum
tariffs by large importers and which is why China should replace the JV mechanism for
technological diffusion with other ways to strengthen its technological capability. The
third conclusion is that the state subsidies component of China’s industrial policy is too
large because it has been used too often as macro-stabilization and socio-stabilization
instruments, resulting in the phenomena of ghost cities and zombie firms.
On the U.S. concern about whether China trade weakens its national security, the
first conclusion is that the notion of national security that is commonly adopted in the
U.S. trade policy debate is ignorant about the primary determinants of U.S. capability in
innovation. By focusing instead mainly on how to hold down China technologically, the
long-run outcome will be a technologically weaker U.S. and hence a more vulnerable U.
S. The second conclusion is that the U.S. must identify a clear, short list of critical
technologies and critical infrastructure for the recently reformed Committee on Foreign
Investment in the United States (CFIUS) to cover, and update this list constantly.
Otherwise, the broad and changing nature of notions about national security would
allow the bureaucratically driven phenomenon of mission-creep to steadily expand the
coverage of the CFIUS process, thereby steadily rendering CFIUS to be operationally
capricious.

The dispute over China’s chronic trade surpluses, and its exchange rate
policy
Figure 1 uses the GDP to normalize the trade imbalance to give a better measure of
its impact on the economy. China’s trade account surplus has been over 2 percent of
GDP since 1996, averaged over 5 percent in the 2005–2008 period, and attained 8.6
percent in 2007. The relevant point is that China’s trade surpluses in the last 20 years
(1997–2016) has not only been persistent, but also large enough in size – the average
amount being 3.8 percent of GDP – to create much discontent in many developed
countries, particularly in the U.S., about displacement of labor by imports from
China.
Figure 2 shows the overall U.S. trade account balance and the bilateral U.S.-China
trade account balance over the 1992–2017 period.2 The overall U.S. trade account
deficit enlarged rapidly from 1.52 percent of GDP in 1992 to peak at 6.04 percent of
GDP in 2006. The overall U.S. trade account deficit has settled at about 4 percent of
GDP for the past five years, 2013–2017. The fact that post-crisis U.S. continues to
borrow a large amount annually from overseas suggests that the overspending and
under-saving behavior of the U.S. economy is structural in nature not cyclical. The
outstanding practitioner of these twin traits is the Government of the United States,
whose military expenditure continues to soar, and whose taxes are cut further to pay off
the plutocrats who had financed the elections.
4 T. LIU AND W. T. WOO

Figure 1. China: Current Account Balance in Balance of Payments, 1978-2016.

Given the large shrinkage of the U.S. trade balance after 2006, and the expansion of
the bilateral U.S.-China trade deficit after 2006, the latter now accounts for a much
larger part of the former. The bilateral U.S.-China trade deficit has grown from about
17 percent of the overall trade deficit in 1993–1994 to 46 percent in 2016–2017. It is no
wonder that the U.S. policy community and U.S. general public have now been
persuaded to regard China as the major cause of its de-industrialization by imports.
Many analysts have accused China of the mercantilist policy of keeping the Renminbi
(RMB) undervalued vis-à-vis the U.S. Dollar (USD).
The impact of China’s trade and industrialization policies on the U.S. economy has
doubtlessly been real and substantial, but it is unfortunate that a lot of the discussion
has been characterized by analytical confusion over basic economic concepts. Nothing
reflects the pervasive misunderstanding of U.S.-China economic interaction better than
the appearance of two essays on the page A17 of the U.S. edition of the Wall Street
Journal on 7 May 2018.
At the top of that page in the Wall Street Journal, Niall Ferguson and Xiang Xu
(2018) concluded that:

What’s required, in short, is a new balance. This can be achieved only if China gives
ground and commits itself to reducing its bilateral trade deficit with the U.S.

Many readers of the Wall Street Journal of that day must have experienced cognitive
dissonance when they reached the second essay at the bottom of the same page. This
second essay is an obituary to the famous economist, Leland Yeager, by his student,
David Henderson (2018), who noted that:
 CHINA ECONOMIC JOURNAL 5

Figure 2. USA: Merchandise Trade Balance in Balance of Payments, 1992-2017.

Just this March, Yeager pointed out that in a world of many nations, President Trump is
mistaken to single out a gap between U.S. exports to China and Mexico and the larger U.S.
imports from those two countries.

The basic analytical confusion over the appropriate measure for ‘trade imbalance’ is also
found in the appropriate measure for the ‘equilibrium exchange rate’. We will argue
later that, while it is true that the RMB has generally been undervalued, the extent of its
undervaluation had been greatly exaggerated by critics because of incorrect definitions
of the equilibrium exchange rate, and because they did not take into account the
existence of China’s capital controls and the inevitability of their removal.

What is the correct value for the exchange rate?

The economics profession defines the equilibrium market price of an item to be the
price that equates the supply with the demand for that item (i.e. the equilibrium
exchange rate is the market-clearing exchange rate in the absence of central bank
interventions). Table 1 reports the recent balance of payments (BOP) for China and
the RMB-USD exchange rate.3 Column (i) shows that China’s net current account (CA)
has always been in surplus, rising from 1.69 percent of GDP in 2000 to 9.94 percent in
2007 and then declining to 1.34 percent in 2017. The non-reserve financial account
(FA), column (iii), was mostly in surplus and that it registered significant deficits in
2015 and 2016 when capital controls were relaxed. We want to note for future discus-
sion that the Errors and Omission component (EO), column (v), became substantially
negative in the 2015–2017 period, with the largest negative values when net non-FA was
in large deficits.
6 T. LIU AND W. T. WOO

Table 1. China: components of balance of payments and RMB-USD exchange rate, 2000–2017 net
balance of each component as percentage of GDP.
Memo items
Capital Non-reserve Errors & Balance of Capital-
Current acct financial acct omissions payments surplus RMB-USD exchange financial acct
acct (CA) (KA) (FA) (EO) (BOP) rate (period average) (KFA)
(i) (ii) (iii) (iv) (v) (vi) (vii)
2000 1.69 0.00 0.16 −0.97 0.87 8.278 −0.82
2001 1.30 0.00 2.60 −0.36 3.53 8.277 2.23
2002 2.41 0.00 2.20 0.53 5.13 8.277 2.73
2003 2.59 0.00 3.31 0.50 6.39 8.277 3.80
2004 3.53 0.00 5.53 0.66 9.72 8.277 6.19
2005 5.79 0.18 3.99 1.00 10.97 8.195 5.17
2006 8.42 0.15 1.65 0.13 10.35 7.973 1.92
2007 9.94 0.09 2.57 0.37 12.97 7.607 3.03
2008 9.15 0.07 0.81 0.41 10.43 6.948 1.28
2009 4.76 0.08 3.81 −0.81 7.83 6.831 3.07
2010 3.90 0.08 4.63 −0.87 7.73 6.770 3.83
2011 1.80 0.07 3.43 −0.18 5.12 6.461 3.32
2012 2.52 0.05 −0.42 −1.02 1.13 6.312 −1.39
2013 1.54 0.03 3.57 −0.65 4.49 6.196 2.95
2014 2.25 0.00 −0.49 −0.64 1.12 6.143 −1.13
2015 2.75 0.00 −3.93 −1.92 −3.10 6.227 −5.85
2016 1.81 0.00 −3.72 −2.05 −3.96 6.640 −5.77
2017 1.34 0.00 1.21 −1.81 0.75 6.746 −0.60
Note: We definite.
(1) KFA = KA + FA + EO.
(2) BOP = (i) + (ii) + (iii) + (iv).
(3) BOP = the negative of Reserve Financial Account (RFA) by accounting necessity.

The overall BOP, sum of columns (i) to (iv), was in deficit only in 2015–2016.4 The
BOP surpluses in the 2000–2017 period were generally large (over 5 percent of GDP)
because of the twin surpluses of CA and FA. The movements of the RMB-USD
exchange rate were in line with China’s BOP position, strengthening from 8.3 in 2000
to 6.1 in 2014 and then weakening to 6.7 in 2017 with the relaxation of capital controls
in 2015–2016 and the smaller CA surpluses. The fact that BOP was almost always in
surplus is prima facie evidence that the People's Bank of China (PBC) had been
preventing the RMB from strengthening to its equilibrium (market-clearing) value.
While it is intellectually fulfilling to show conclusively that the RMB is generally
undervalued, the important information that is needed for policymaking is the degree
of undervaluation. A RMB undervaluation of 20 percent will merit a policy response
from the U.S. government, but an undervaluation of 10 percent or lower might not be
worth reacting to. There are two commonly used methods to compute the equilibrium
exchange rate (a) the purchasing power parity (PPP) approach, and (b) the price-
elasticity approach

The PPP approach

The PPP approach posits ‘that in the long run exchange rates should move towards the
rate that would equalize the prices of an identical basket of goods and services ... in any
two countries’.5 This view inspired The Economist magazine to construct a PPP
exchange rate based on the prices of Big Mac sandwiches sold in different countries.
In January 2018, with the actual exchange rate being 6.43 RMB per USD it cost 20.4
 CHINA ECONOMIC JOURNAL 7

RMB to buy a Big Mac in China, and $5.28 in the U.S. So is it meaningful to say that the
Chinese exchange rate was undervalued by almost 40 percent in January 2018?
The answer is no because the US and Chinese baskets of goods included non-
tradable inputs, and the relative prices of non-tradables are lower in China than in
the U.S. because labor costs are lower in the former. To see that the gap between the
usual PPP exchange rate and the actual exchange rate reflects the development gap
between the two countries, we first make the following definitions:

(a) Defining the consumer price index in China and U.S.

CPI of China; CPIC ¼ð1  aÞ PC T þ aPC N

CPI of United States; CPIU ¼ð1  aÞ PU T þ aPU N

where CPI = consumer price index

C = China
U = United States
PiT = price of tradable good in country i
PiN = price of non-tradable good in country i
a = weight of non-tradable goods in price index
(b) Defining the PPP exchange rate

ePPP ¼ CPIC =CPIU

We next state three equilibrium conditions.

(1) Goods arbitrage

PC T ¼eactual PU T

where eactual = actual (nominal) exchange rate expressed as number of RMB per USD
(2) Relationship between prices of tradables and non-tradables within each country

for developing China;PC N ¼ dPC T

for developed United States;PU N ¼ fPU T

(3) The difference between developed and developing country is that relative price of
non-tradables is higher in the former
f>d>0

We can now derive the following relationship between the PPP exchange rate and the
actual exchange rate:

ePPP ¼ CPIC =CPIU

ePPP ¼½ð1  a þ adÞ=ð1  a þ af Þ eactual

8 T. LIU AND W. T. WOO

ePPP <eactual

The above exercise shows that the actual exchange rate of a developing country would
always be ‘undervalued’ in relation to the PPP exchange rate, and it would be impos-
sible for the developing country to set its exchange rate equal to the PPP exchange rate.
The optimistic conclusion from the above analysis is that as China continues catching up
with the standard of living in the U.S., China’s value of ‘d’ would converge to the U.S.
value of ‘f’, finally making the ‘equilibrium exchange rate with open KFA’ identical to the
‘PPP exchange rate’.

The price elasticity approach

This approach starts by assuming some values for the price elasticities of exports and of
imports, and then works backward from the actual value of the exchange rate to the
exchange rate that is consistent with a CA balance that is equal in size but opposite in
sign to a given capital-financial account (KFA) balance. Specifically, Goldstein (2006)
imposed the following assumptions on the accounting identity CA + KFA + RFA = 0:
(a) KFA is exogenous and equals 1.5 percent of GDP, and (b) CA is a function of only
one variable, the RMB-USD exchange rate, e, with some assumed values for the price
elasticities of import and export. Goldstein then calculated the value of e that would
make CA + KFA = 0, and he called this computed value of e the equilibrium exchange
rate. This is the basis of Goldstein’s (2007) claim in his Congressional testimony that
the RMB was undervalued by 40 percent in March 2007.
The capriciousness of the size and the sign of this exogenously set KFA balance is
obvious. If KFA is 1.5, then equilibrium CA is −1.5 by accounting necessity. It is just
impossible to justify that the equilibrium CA (hence the value of the equilibrium
exchange rate) is an exogenous value that is independent of domestic and foreign
macroeconomic policies.6 The scenario that would make KFA an exogenous positive
number is to have capital controls that prevents domestic residents from sending capital
out and accepts less capital inflow than offered by foreigners. In short, the Goldstein-
imputed exchange rate is the ‘equilibrium exchange rate under stringent capital
controls’.
Figure 3 shows the degree of RMB undervaluation in the 2000:1Q to 2017:4Q period,
under three different assumptions of price elasticities,\when actual values of KFA are
used in the Goldstein calculations. We assume

● the best estimates of the elasticities to be the import-price elasticity of 0.906 and
export-price elasticity of 1.111 from Cheung, Chin and Qian (2012)
● the low elasticity case to be when both elasticities are 0.8; and
● the high elasticity case to be when both elasticities are 1.2

Figure 3 shows RMB undervaluation of over 10 percent in the 2001:3Q – 2011:2Q

period, with an average overvaluation of 18 percent in 2004:4Q – 2008:1Q sub-period.
The factor behind this sustained overvaluation after 2001:3Q was the successful con-
clusion of U.S.-China negotiations over China’s WTO membership on 16 November
 CHINA ECONOMIC JOURNAL 9

Figure 3. Goldstein-Style Calculations of Undervaluation of the RMB-USD Exchange Rate, 2000-2017.

1999 that led to formal WTO accession on 11 December 2001. As pointed out by
McKibbin and Woo (2003), the concluded U.S.-China negotiations in 1999 eliminated
the annual uncertainty over whether China would be granted most favored nation
(MFN) status by U.S. Congress for the following year, and this reduced the risk
premium that inward FDI demanded in order to operate in China. The consequence
was large inward FDI for a sustained period, causing CA and FA to be high. Combining
this twin surplus in BOP with China’s virtual dollar-peg exchange rate policy, RMB
undervaluation became substantial. The undervaluation diminished with the steady
appreciation of the RMB from 2006:4Q onward and the eventual slowdown in
inward FDI.
An important change in China’s external economic situation occurred in 2014:3Q
when the direction of capital flow made a sustained reversal to make KFA deficit the
new norm. The most important reasons for this change was the loosening of capital
controls that allowed Chinese residents to diversify out of their RMB-denominated
asset portfolios. The thirst for asset diversification in China is hard to exaggerate. If
capital controls had been lifted in 2003, the great rush of funds outward would have
started then.
The overvalued RMB since 2014:3Q from the relaxation of capital controls allows us
to see two important flaws in the policy recommendation of drastic RMB appreciation
by Nicholas Lardy and his colleagues at the Peterson Institute during the 2003–2008
period.7
The first major flaw in the Goldstein-Lardy policy recommendation is about the
correct reference rate to calculate overvaluation. The actual RMB-USD exchange rate
10 T. LIU AND W. T. WOO

in 2003 was 8.3, and the Goldstein reference rate is 6.4. However, because the value of
6.4 is based on the existence of China’s capital controls that kept KFA to be positive the
free market exchange rate in the absence of capital controls could have been 7.0.8 Now
compare the following two methods of exchange rate management.
The first method consists of two parts (1) free the exchange rate without freeing
capital flow, and (2) after a couple of years, free the capital controls. The outcome
would be the exchange rate first moving from 8.3 to 6.4 and staying there. When the
capital controls are removed, the exchange rate would move to 7.0. In this first method,
there would be exchange rate overshooting, and adjustments in the composition of
production. This first method of exchange rate management is the method recom-
mended in Goldstein and Lardy (2003)
The second method of exchange rate management is to appreciate the exchange rate
gradually. Now suppose that value of the exchange rate was 6.8 when both exchange
rate and capital flows were freed, the exchange rate would then move from 6.8 to 7.0. In
this second method, the amount of exchange rate overshooting is smaller and the
adjustments in the composition of production would hence also be smaller. This second
method of exchange rate management is more efficient than the first method because
it’s the cost of reorienting production would be lower.
Given China’s objectives of internationalizing the RMB and making Shanghai a top-
tier international financial market, it is inevitable that China will open its FKA. One
could, therefore, reasonably argue that the correct equilibrium exchange rate to use for
analysis is the ‘equilibrium exchange rate without capital controls’ and not Goldstein’s
‘equilibrium exchange rate with stringent capital controls’.
The second major flaw in the Goldstein-Lardy policy recommendation comes from
the ‘big picture’ question about Figure 3 which reports the deviations of the actual
exchange rate from the equilibrium exchange rate. Is it harmful to have exchange
rate deviations? Morris Goldstein and Nicholas Lardy certainly thought that they
were harmful.
We have two reasons for our disagreement with the Goldstein-Lardy conclusion
about the harmful effects. First, there is no economic rationale to justify why zero
exchange rate deviations should be a desirable objective in itself unlike full employment,
price stability, and dynamic growth. A floating exchange rate regime would have
automatically produced zero deviations, but the choice of the exchange rate regime
should be made within the context of the economic management framework of the
country and not by the desire to generate a zero BOP at every moment in time.
The second reason for our disagreement is that Figure 3 is an accounting construct
based on Goldstein’s assumptions of KFA being exogenous and CA being a function
only of the exchange rate. Both assumptions are indefensible, and so Figure 3 cannot be
used to guide exchange rate management. Capital flows are generally not independent
of the value of the exchange rate. When China joined WTO, it attracted a much larger
amount of inward FDI that helped to boost export (and CA). If China had reacted by
appreciating the RMB by 20 percent, much of the subsequent capital inflows and export
boom would not have occurred, and Chinese growth would have been lower.
Why should it be preferable for China to reduce a BOP surplus through RMB
appreciation than through a larger fiscal deficit from higher infrastructure investment?
The former would have lowered growth and the latter would have increased it. The
 CHINA ECONOMIC JOURNAL 11

Goldstein-Lardy policy framework that produced Figure 3 should not be used to guide
exchange rate policy because the exchange rate is a policy instrument and not a policy
objective in itself.

The ‘Plaza Accord 2.0’ proposal represents the triumph of hope over
experience
On 22 September 1985, Japan, the United Kingdom, France and West Germany signed
the Plaza Accord with the U.S. to appreciate their currencies collectively against the
USD in order to shrink the protracted swinging U.S. trade deficits. The average Yen-
USD exchange rate appreciated the most, going from 238 Yen per USD in 1985 to 145
in 1987, and then staying at around 128 in 1988.9 Given this success in generating a
large Yen appreciation quickly, it has become common since 2005 for analysts to call
for a Plaza Accord 2.0 to engineer a significant RMB appreciation to reduce global trade
imbalances.10
This call for a Plaza Accord 2.0 is wrong because it is based on ignorance of the
global trade adjustment that occurred after September 1985. The trade data in Table 2
clearly shares that the 1985 Plaza Accord did not reduce the U.S. global trade deficit.
When the average Yen-USD exchange rate appreciated by 40 percent in 1985–1988
period, Japan’s global CA surplus declined from 3.76 percent of GDP to 2.74 percent, a
drop of 1.02 percentage points. The U.S. global CA deficit, on the other hand, showed
little change, going from 2.1 percentage of GDP to 1.7 percent, a drop of 0.4 percentage
points. In short, the sizable appreciation of the Yen against the USD had substantial
impact on the Japanese global trade imbalance but almost no impact on the U.S. global
trade imbalance.
The huge appreciation of the Yen-USD exchange rate did cause a sizable decrease in
the bilateral U.S.-Japan trade imbalance. The bilateral Japan-U.S. trade surplus declined
from 3.64 percent of Japan’s GDP in 1985 to 1.86 percent in 1988, a reduction of 1.78
percentage points. The drop in the bilateral Japan-U.S. trade surplus was even greater
than Japan’s global trade surplus, revealing that the Plaza Accord caused Japan to start
running a larger bilateral trade surplus against some other countries.
The mechanism that caused Japan’s bilateral trade surplus with non-U.S. countries to
increase under the Plaza Accord was the same mechanism responsible for the small

Table 2. The Plaza Accord, 22 September 1985: impact of Yen-USD appreciation in 1985–1988 on
current account balances of Japan and the United States.
Exchange rate (Yen/US$) Global current account balance (% of own GDP)
Bilateral Japan-U.S. trade balance
end of period period Japan United States (% of Japanese GDP)
1984 251.10 237.52
1985 200.50 238.54 3.76 −2.10 3.64
1986 159.10 168.52 4.24 −2.58 2.90
1987 123.50 144.64 3.52 −2.69 2.43
1988 125.85 128.15 2.74 −1.70 1.86
1989 143.45 137.96
Source: Data is from IMF ‘International Financial Statistics’ and ‘Direction of Trade’.
Global Current Account Balance i = 100*(series 90c.c – series 98c.c + series 98.nc)/(series 99b.c).
Bilateral trade balance = export – import, using U.S. data.
12 T. LIU AND W. T. WOO

improvement in the U.S. global CA deficit. With the gigantic appreciation of the Yen
against the USD, Japanese companies started investing in production facilities in
Southeast Asia and other developing countries, and began exporting to the U.S. from
there. Japan’s bilateral trade surplus with non-U.S. countries increased because of
increased Japanese export of capital equipment to Japanese-affiliated companies in
these countries. U.S. global CA surplus hardly changed because while the U.S. imported
less from Japan, it imported more other countries.
The unambiguous implication of an equally dramatic appreciation of the RMB
against the dollar is that it could greatly reduce the bilateral U.S.-China trade deficit
but this move would only hurt China and not reduce significantly the size of the overall
trade deficit of U.S. The economic reasoning involved is straightforward. Ceteris
paribus, in the aftermath of a 40 percent RMB appreciation, foreign companies produ-
cing in China for the U.S. market would move their operations to other Asian
economies (e.g. Vietnam and India) and export from there, and U.S. would start
importing the same goods from other Asian countries instead. In the absence of a
collective appreciation of all Asian currencies, the RMB appreciation would only reconfi-
gure the Asian distribution of trade imbalances and not eliminate the trade imbalance of
the U.S. The many calls for a Plaza Accord 2.0 to reduce the U.S. trade account deficit
are simply wrong-headed.

Understanding the evolution of China’s CA balance

There are quite a number of China-centric explanations11 for China’s chronic trade
surplus, and we will discuss the two that seems the most credible:

(1) the dysfunctional financial market theory that attributes the imbalance to the
inability of China’s largely unreformed financial system to intermediate all
savings into investment, and
(2) the aggressive industrial policy theory that attributes the trade imbalance to
China’s promotion of exports and suppression of imports.

The dysfunctional financial market theory focuses on the aggregate-level accounting

identity that the overall CA balance is determined by the fiscal position of the govern-
ment, and the savings-investment decisions of the state-controlled enterprises (SCEs)12
and the private sector. For the last decade, the Chinese fiscal position has been a small
deficit, and so it is not the cause for the swelling CA surpluses in the 2000s. The CA
surplus exists because the sum of savings by SCEs and the private sector exceeds the
sum of their investment expenditures; and it has expanded steadily because the non-
government savings rate has been rising faster than the growth of nongovernment
investment.
Why has China’s financial system failed to translate the savings into investments?
Such an outcome was not always the case. Before 1994, the voracious absorption of
bank loans by SCEs to invest recklessly kept the CA usually negative and the creation of
nonperforming loans (NPLs) high. When the government implemented stricter con-
trols on the state-owned banks (SOBs) from 1994 onward (e.g. removing top bank
officials whenever their bank lent more than its credit quota or allowed the NPL ratio to
 CHINA ECONOMIC JOURNAL 13

increase too rapidly), the SOBs slowed down the growth of loans to SCEs. This cutback
created an excess of savings because the SOB-dominated financial sector did not then
rechannel the released savings (which were also increasing) to finance the investment of
the private sector.
This failure in financial intermediation by the SOBs is quite understandable. First,
the legal status of private enterprises was, until recently, lower than that of the state
enterprises; and, second, there was no reliable way to assess the balance sheets of the
private enterprises, which were naturally eager to escape taxation. The upshot was that
the residual excess savings leaked abroad in the form of the CA surplus. Inadequate
financial intermediation has made developing China a capital exporting country!
This perverse CA outcome phenomenon in China is not new. Up to the mid-1980s,
Taiwan experienced this same problem when all Taiwanese banks were state-owned and
were operated under a civil service regulation that required each loan officer to repay
any bad loan that she approved. The result was a massive failure in financial inter-
mediation that caused Taiwan’s CA surplus to be 21 percent of GDP in 1986. The
reason why China has not been producing the gargantuan CA surpluses seen in Taiwan
in the mid-1980s is the still large amount of SCE investments.
The important point is that savings behavior is not independent of the sophistication
of the financial system; Liu and Woo (1994). An advanced financial system will have a
variety of financial institutions that would enable pooling of risks by providing medical
insurance, pension insurance, and unemployment insurance; and transform savings
into education loans, housing loans, and other types of investment loans to the private
sector. Ceteris paribus, the more sophisticated a financial system, the lower the savings
rate.
The second credible theory for China’s chronic trade surplus is the aggressive
industrial policy explanation. This second theory views China’s anomalous trade imbal-
ance situation to be the unintentional outcome of, one, the overriding economic and
political priority in China to create jobs for its underemployed (surplus) labor force;
and, two, the widespread belief in the efficacy of infant industry protection. The
resulting mix of export-promotion measures and import-suppression measures accel-
erated the simultaneous growth of export firms (which increased exports) and import-
competing firms (which decreased imports), and hence kept the trade balance in
surplus.13
There is now adequate evidence, however, that a large component of China’s
industrial policy has actually reduced China’s welfare in addition to enlarging its
trade surplus, especially in the 2008–2017 period. Woo (forthcoming) pointed out
that the Chinese government’s practice of bailing out loss-making SCEs had caused
the SCEs to overinvest, resulting in huge excessive capacity in the heavy industries
and crowding out of the private sector. The former outcome had led many SCEs to
dump their products in foreign markets and worsened China’s trade imbalance. The
return on equity (ROE) for SCEs has dropped from 15.6 percent in 2007 to 7.0
percent in 2017.14
Clearly, the lowering of tension in trade disputes with the U.S. would require that (a)
China accelerates the development of its financial sector if the dysfunctional financial
market theory is correct; and/or (b) China reduces export incentives and import
barriers – especially from the rent-seeking industries with low rates of ROE if the
14 T. LIU AND W. T. WOO

aggressive industrial policy theory is correct. The important point is that, regardless of
which theory is right, both actions should be undertaken because they both enhance
China’s economic welfare, with one of them also lowering the probability of a trade war
with the U.S.
As to how the U.S. should react to China’s subsidy-cum-tariff type of industrial
policy, we begin by making two points. The first is that WTO rules allow developing
countries to engage in some protectionist measures to nurture their industrialization.
The second point is that China’s industrial policies have only accelerated an economic
development process that has been unfolding since 1978. The final outcome of low
value-added industries in the U.S. being displaced by Chinese imports is inevitable
because the U.S. is a capital-rich country and China is a labor-rich country.
The U.S. policy package to deal with the closing of these low value-added firms due
to Chinese exports should contain three common elements with the U.S. policy package
to deal the closing of low-tech firms due to technological changes. The three common
elements are

(1) a U.S. unemployment insurance scheme that incentivizes acceptance of low-wage

jobs (e.g. a negative income tax system)
(2) widely accessible U.S. job retraining programs that are effective, and
(3) STEM15 programs in U.S. high schools and universities that are high quality and
attractive to the average student.

We have identified an array of structural factors and macroeconomic policies behind

the U.S. and Chinese trade imbalances (e.g. dysfunctional financial markets in China
and large government budget deficits in the U.S.). Instead of insisting on RMB
appreciation as the primary method for reducing U.S. unhappiness with the trade
deficits, it is more efficient (a) to directly address the specific reasons behind the
trade imbalance in each country, and (b) to strengthen the above three job transition
programs to deal with the loss of low-skill jobs in the U.S.

The dispute over China’s industrial policy

Because the proven way to increase economic prosperity is to increase productivity, It
has been standard practice for a government to strengthen the country’s indigenous
capacity to innovate, and to accelerate the acquisition of innovations from abroad.
China’s government is no exception.16 China’s latest plan in industrial upgrading is the
Made in China 2025 (MC-25) initiative unveiled in 2015. MC-25 aims to establish
China as a ‘manufacturing powerhouse’ with global dominance in new high-tech areas
like artificial intelligence, robotics, advanced micro-chips, new energy vehicles, aviation
and space travel, autonomous driving systems, solar cells, machine tools, biopharma-
ceuticals, medical devices, telecom devices, and electronic sensors. The first step in
China’s planned journey to global leadership in high-technology is the achievement by
2025 of ‘self-sufficiency’ in the materials and parts used in the high-tech products. ‘Self-
sufficiency’ is defined as local content comprising 70 percent of the product.
The ambitious range of high-tech products in MC-25 and its intended clustering of
most parts of the production chain within China have sent tremors through the high-
 CHINA ECONOMIC JOURNAL 15

tech business community and government ministries in the rest of the world. Since
there was a perception that China had in the past frequently used industrial policy
instruments that were not WTO-sanctioned in order to reach its present technological
level, many U.S. observers saw MC-25 as a ‘China’s government-led drive .. [that would
break] international rules to build cutting-edge industries of the future’.17
Peter Navarro (2018), a policy advisor to President Trump, has recently summed up
his view of what China had been doing as follows:
In textbook economics, trade is a win-win .. [but] America’s trade with China is as far
from that model as the Earth is from Mars . . ...Why is the textbook model failing? The
answer is .. [China’s] state-directed investments, nonmarket economy, and disregard for
the rule of law.
The problem’s taproot is Chinese intellectual-property theft and the forced transfer of
foreign technology as a condition of accessing China’s market . . .. [which allowed] Chinese
companies to move rapidly up the innovation curve at much lower cost than their foreign
competitors, which must recoup the cost of research and development through higher
prices.

The emerging view that is gaining influence rapidly is that the real dispute in U.S.-
China economic interaction is not the size of China’s trade imbalance but China’s
intellectual piracy. As David Joy, Chief Market Strategist for Ameriprise Financial, said:
To me, that’s [forced technology transfer is] actually the biggest issue, more even than
currency valuation. Being forced to give up technology for access to market is essentially
blackmail.18

And Chuck Schumer, the Minority Leader in the U.S. House of Representatives, has
criticized the perennial focus of U.S. administrations on the bilateral U.S.-China trade
deficit as asinine:
China’s trade negotiators must be laughing themselves all the way back to Beijing . . ..
They’re playing us for fools – temporary purchase of some goods, while China continues
to steal our family jewels, the things that have made America great: the intellectual
property, the know-how in the highest end industries. It makes no sense.19

U.S. dissatisfaction with China trade has now expanded from unhappiness over loss of
U.S. jobs due to exchange rate manipulation by China to include discontent over the
loss of future high-paying jobs in high-tech industries because of forced technology
transfer to China.
We organize our evaluation of the recent round of charges of unfair trade practices
by China by discussing the three main instruments of China’s industrial policy identi-
fied by their critics20:

(1) import restrictions (e.g. tariffs, quotas),

(2) production subsidies (e.g. export subsidies, low interest loans, cheap land, pre-
ferential tax rates), and
(3) forced transfer of technology (e.g. conducting industrial espionage, demanding
the surrender of production technology in exchange for market access, imposing
local content requirements)
16 T. LIU AND W. T. WOO

Import restrictions and production subsidies

Because learning-by-doing is an irrefutable phenomenon, it is often used to justify the
use of import restrictions to induce the establishment of the target new industry. Such
examples abound in China: China’ ban on Google created Baidu, China’s ban on
Twitter created Weibo, China’s ban on WhatsApp created WeChat, China’s ban on
PayPal created Taobao, and China’s ban on eBay created Alibaba. While these bans are
bad for the U.S. companies concerned, they could have increased consumer surplus
worldwide because it is now commonly acknowledged that the services provided by
WeChat and Alibaba are at least as good as those of WhatsApp and Amazon.
As noted earlier, WTO rules allow developing economies to use tariffs and subsidies
to nurture some types of new industries, especially technologically advanced industries.
It is usually only in the case where subsidies are used to expand production beyond
domestic demand, resulting in significant exports, that the impacted country has a
convincing complaint about the exporting country’s violation of WTO protocol.
However, after 40 years of fast economic development, China’s continued use of
WTO-sanctioned incentives to promote infant industries is no longer viewed sympathe-
tically in the advanced countries. Pascal Lamy (former Director-General of WTO) has
pointed out that China is now not only the second largest economy in the world, but
also the biggest producer of a wide range of products (e.g. cement and desktop
computers) and he concluded that:
[it is dishonest for China to pretend that it is] like India, or like Senegal, or like Botswana
. . .. [China still had to do more to] ensure a level playing field between Chinese producers
and foreign producers, whether they produce inside China or outside of China.21

Our discussion of China’s use of import restrictions and production subsidies must not
leave the impression that they have been very beneficial for China’s economic growth.
This is because the present condition of pervasive excess industrial capacity and the
incongruous twin phenomena of inland ghost cities and coastal real estate bubbles are
also products of China’s production subsidies system. China’s inability to enforce hard
budget constraints on SCEs is now threatening the financial sector with an explosion of
nonperforming loans, and undermining overall total factor productivity growth
through crowding-out of the private sector. It is, therefore, wrong to give a glowing
assessment of China’s system of import restrictions and production subsidies as being
good for China despite its successful nurturing of manufacturing powerhouses like Hai
Er and of cutting-edge technology firms like Huawei.

Forced transfer of technology

A foreign firm that wishes to sell its products in China is sometimes told that its
market access is conditional upon setting up production facilities in China in the
form of a JV with a major government-linked company (who could later become a
future competitor in markets outside of China). If it were Singapore instead of China
which presented this choice to the foreign firm, the foreign firm could well decide to
forgo the small Singapore market. But because the Chinese market is not only very
large and because there are other competing foreign firms also seeking access to
 CHINA ECONOMIC JOURNAL 17

China’s market and possessing similar technology, a foreign firm will be more willing
to trade its production technology for monopoly access to China’s market.
The outcome from the above practice by China is effectively the equivalence of
getting a lower price for the foreign-originated product in the long term. This outcome
is very similar to the bulk discount that big buyers are able to extract from their
suppliers, and very similar to the ‘optimum tariff’ that a large importer is wont to
impose on its trade partner. In essence, the buyer in both cases is using her market
power to extract a lower price for the product.
Is the exercise of market power wrong? Frankly, we are not sure because there has
been no wide public outcry against Walmart’s well-known practice of demanding and
receiving big discounts from its suppliers. But Martin Feldstein (2018) is sure that it is
wrong. Otherwise, he would not have called the ‘willing-buyer willing-seller’ defense of
this Chinese method of acquiring technology ‘disingenuous’.
U.S. firms have long complained quietly but bitterly to U.S. government officials
about China’s use of its market power to pay an effectively lower price for the good. As
mandated technology transfer contravenes WTO rules on market access, it is therefore
a puzzle that it is only now that the U.S. government is willing to take action against
China’s economically aggressive act of ‘forced technology transfer’. The past reluctance
to act could have been influenced by factors like (a) the absence of a coordination
mechanism among the competing foreign firms to collectively reject China’s demand
and to collectively request their governments to file WTO complaints; (b) the percep-
tion by the U.S. government that the technology involved is not frontier technology that
is critical for overall U.S. competitiveness and for U.S. national security; and (c) the
importance of China as an ally in international affairs.
The recent turn-around in U.S. policy on mandated technology transfer is likely to
have been due to a combination of developments like (a) the technology that China is
now demanding is truly frontier technology that is necessary for the development of the
next generation of high value-added products; (b) the recognition that China is turning
out to be more of a strategic competitor than a potential strategic partner; and (c) the
sense that China should not be treated like a developing economy because it has, after
all, become the biggest aid donor in Africa and many parts of Asia.
Given the strong likelihood that the U.S. would be able to mobilize its biggest G7
allies to join in retaliatory actions against China’s JV requirement for market access,
China should start using other ways to accelerate technology transfer. This new
behavior by China is the same as the non-imposition of optimum tariffs by large
countries. A new phase in China’s use of industrial policy tools has arrived.

The conflation of national security concern with economic competition

CFIUS is an interagency body that reviews transactions that would give control of a U.
S. firm or technology to a foreign entity, and rejects those that would hurt the national
security of the U.S. The truth is that CFIUS faces extreme difficulties in doing its job
well, and this point is brought home most glaringly when one considers the following
two cases.
18 T. LIU AND W. T. WOO

Case 1: CFIUS would approve transactions where the product/technology has no military
applications and reject transactions where the product/technology has military applica-
tions. However, most products and technologies can be weaponized. A KGB agent could
put advertisements for vodka on a website or he could put up fake news to help get Donald
Trump elected a second term.

Case 2: The level of national security of a country depends on the quality of its weapons.
The richer the country, the higher the quality of weapons it could afford. Since economic
power is the basis of national security, should CFIUS ever approve the sale of any
productivity-enhancing technology to Russian firms?

In short, if CFIUS is to take its job literally, ‘CFIUS really should be managing all
global trade’.22
The Made in China 2025 (MC-25) program states explicitly that it will also seek to
buy the next generation of high-technology (e.g. buy promising start-ups). There is
hence great fear in U.S. and other advanced countries that the next generation of high-
technology could be appropriated by Chinese firms, possibly, sometimes even through
unfair means. Laskai (2018) reported that:
Circumstantial evidence confirms this suspicion . . . Take the example of Fujian Grand
Chips, a purportedly private Chinese company that attempted to acquire German machine
maker Aixtron in 2016. Shortly before it staged a public takeover of Aixtron, another
Fujian-based company San’an Optoelectronics canceled a critical order from Aixtron on
dubious grounds, sending its stock tumbling and presenting Fujian Grand Chips with an
opportunity to swoop in. Both Fujian Grand Chip and San’an Optoelectronics shared a
common investor: an important national semiconductor fund controlled by Beijing. The
acquisition was stymied by an 11th-hour intervention by government officials but demon-
strated how Beijing can drive investing abroad, often in a highly coordinated manner.

Given the possible conspiratorial nature of the actions by the two Chinese firms in the
preceding quote, one could be misled to conclude that there is paranoia in Washington
DC today when one reads:
Senate Majority Whip, John Comity (R-Texas) regularly warns his colleagues that China is
using private-sector investments to pilfer American technology. China has ‘weaponized’ its
investments in America ‘in order to vacuum up U.S. industrial capabilities from American
companies . . . [The goal is] to turn our own technology and know-how against us in an
effort to erase our national security advantage’.23

Since the word ‘pilfer’ in the Comity quote means to ‘steal’, it is befuddling when one
reads that Peter Navarro (2018) sees the opposite outcome in China’s purchases:
[China has been] targeting American companies based on strategic and military goals
rather than pure economic considerations . . . [and hence have been] often willing to pay
distortive prices, far above what the free market would dictate.

This clash in perception between Comity and Navarro about whether the Chinese are
paying enough for American technology does not necessarily confirm that there is no
consistency in paranoia. It could imply instead that Comity and Navarro have too
broad a definition, and too short-sighted a definition, of national security.
The Comity and Navarro definition is too broad because it automatically equates an
increase in Chinese economic competitiveness with a decrease in U.S. national security.
 CHINA ECONOMIC JOURNAL 19

Since Comity and Navarro do not want the U.S. to anything to strengthen its economic
competitors, they would restrain technology-rich U.S. from selling technology-intensive
goods to foreigners when economic theory shows that this is a mutually beneficial
outcome. The Comity and Navarro definition of national security is also too short-
sighted because U.S. technological dynamism is reinforced when it faces foreign
competition. The immediate short-term outcome in economic competition is a zero-
sum game but the long-run outcome in economic competition is a win-win situation.
Comity and Navarro are correct about national security being dependent on economic
strength, which is in turn strongly dependent on technological capability. But they are
incorrect to believe that the best way to protect and promote U.S. technological capability is
to hold China back technologically. The most effective ways to improve U.S. capability in
innovation is to ensure easy access to high-quality education by all domestic residents, to
attract talented foreigners to study and work in U.S., and to have the government work
effectively with universities and businesses to promote R&D. It is, therefore, most harmful
for U.S. national security for the Trump administration to be cutting funding for education
and R&D and to be whipping up xenophobic sentiments.
Finally, the Comity and Navarro conception of national security is based on the false
notion that Chinese investors (maybe, Chinese bureaucrats) are much smarter than the
Japanese investors who flooded into the U.S. in the late 1980s and early 1990s, buying assets
like the Rockefeller Center 1989 and ending up in tears frequently. Furthermore, their
perception of threat from Chinese investment does not take into account that most start-
ups fail and that Chinese investors cannot afford to buy up all the start-ups that bubble up
in Silicon Valley, Silicon Forest, Silicon Alley, Silicon Prairie and Silicon Slopes – not to
mention other technological centers outside of the U.S. (e.g. Silicon Wadi in Israel, Silicon
Mountain in Cameroon, and Silicon Cape in South Africa).
On 13 August 2018, President Trump signed the Foreign Investment Risk Review
Modernization Act to reform CFIUS to deal with the increasing conflation of economic
competition and national security considerations.24 The scope of CFIUS has been
widened (e.g. it now includes review of activities of hedge funds with minority foreign
participation), and its funding increased. The most important remaining task now is for
U.S. Treasury to draw up a clear, short list of critical technologies and critical infra-
structure for CFIUS to cover and update this list regularly. Otherwise, the broad and
changing nature of notions about national security would allow the bureaucratically
driven phenomenon of mission-creep to steadily expand the coverage of the CFIUS
process, thereby steadily rendering CFIUS to be operationally capricious.

Final remarks
There is a broader context which the U.S.-China trade war fits into. A new international
economic normal is asserting itself with the emergence of China and India as economic
powerhouses alongside North America, Europe, Japan, and Russia. This new interna-
tional economic normal will be consolidated further as other large developing countries
start growing faster. The toppling of U.S. hegemony by the emergence of a multipolar
world has greatly heighted U.S. concern for its national security.
President Trump’s present trade wars on multiple fronts reflect both this heightened
concern for national security and the hesitation of the U.S. in continuing to promote
20 T. LIU AND W. T. WOO

economic globalization. Our prediction is that the settlement of the present U.S.-China
trade dispute will inevitably be followed by new disputes breaking out over other trade
issues until the leaders of the different spheres of influence can agree to deepen multi-
lateral free trade. Economic disputes are a systemic feature of the present uncoordinated
multipolar political order.
Our principal policy suggestion to China is that, because China’s economy in 2018 is
very different from that in 1978 (e.g. there are now many parts of China that look like
Singapore and China is Africa’s biggest donor), there should be more reciprocity in
China’s trade and investment relations with the advanced economies despite China’s
status as a developing economy under WTO rules. China should not only give national
treatment in the near future to more types of foreign firms (e.g. financial institutions), it
should also set up a mechanism to start easing up on foreign acquisition of Chinese
firms in a manner that is consistent with China’s national security concerns.
Our principal policy suggestion to President Trump is to stop equating strategic competi-
tion with economic competition. Strategic competition is normally a zero-sum game while
economic competition is usually a zero-sum game in the short run, but generally creates a
win-win outcome in the long run. National economic dynamism and economic resilience
emerge from a vibrant domestic innovation system that is internationally competitive and not
from trying to prevent other countries from becoming technological powers.

Notes
1. See Bown and Kolb (2018) and Borzykowski (2018).
2. This is the trade imbalance in the trade of goods. There is controversy over the size of the
bilateral trade imbalance, e.g. the official U.S. estimate of the bilateral trade deficit in 1996
is $39.5 bn, and the official Chinese estimate is $10.5 bn. When Feenstra et al. (1999)
corrected these estimates by taking account of the value-added in Hong Kong during
transshipment, the two figures were revised to $26.1 bn and $20.6 bn, respectively.
3. For simplicity in notation, we will refer to the sum of columns (ii), (iii), and (iv) as the
capital-financial account (KFA).
4. By accounting necessity, BOP = the negative of the reserve financial account (RFA).
5. The Economist (2018).
6. The equilibrium CA of a developing country is not always negative, see Liu and Woo
(1994) for an imperfect financial market explanation why the economic development of
Taiwan had been characterized by current account surpluses.
7. See Goldstein and Lardy (2003) and (Goldstein and Lardy 2008).
8. The validity of the point being developed does not rely on the free market exchange rate
with open FKA being 7.0. We know that it has to lie above 6.4 and could even exceed 8.3.
Our point is even stronger when the reference value is higher than 8.3.
9. This fast, large appreciation of the G-5 currencies against the USD from September 1985
to end of 1986 was quickly considered by all to be excessive and destabilizing to global
financial markets. The upshot was that the G-5 and Canada signed the Louvre Accord on
22 February 1987 to halt the slide of USD but sharp Yen appreciation continued.
10. See Pesek (2016).
11. ‘China-centric’ because they ignore the obvious fact that the current account balance is
also determined by foreign, notably U.S., economic conditions.
12. The SCE category covers companies that are classified as state-owned enterprises (SOEs);
and joint-ventures and joint-stock companies, which are controlled by third parties (e.g.
legal persons) who are answerable to the state. To understand the principal-agent
 CHINA ECONOMIC JOURNAL 21

problems in SCEs has shaped China’s macroeconomic performance, see Woo (2006) and
Woo (Forthcoming).
13. The simultaneous expansion of these two sectors meant that the nontradeable sector was
contracting. The undervalued RMB explanation for China’s trade imbalance is actually an
aggressive industry policy explanation. The subsidy-tariff combination is equivalent to the
undervaluation of a currency, see Woo (2004).
14. ROE data are from Cho and Kawase (2018). Also see Tan, Huang, and Woo (2016) for a
discussion on China’s zombie firms.
15. STEM = Science, Technology, Engineering, and Mathematics.
16. See Fu, Woo, and Hou (2016).
17. Bradsher and Rappeport (2018).
18. Isidore (2012).
19. Bennett and Bender (2018).
20. The use of an undervalued exchange rate as an industrial policy tool has already been
discussed adequately in the previous sections of the paper.
21. Bradsher and Rappeport (2018).
22. Observation by Paul Rosenzweig, former CFIUS staff member, quoted by Bennett and
Bender (2018).
23. Bennett and Bender (2018).
24. See McQueen (2018), Rubenfeld (2018), and Klein (2018).

Acknowledgments
We are most grateful to Irene Lu, Shen Yan, Yu Miaojie, and Huang Yiping for their guidance
and patience in the writing of this paper.

Disclosure statement
No potential conflict of interest was reported by the authors.

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22 T. LIU AND W. T. WOO

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